One of the great advantages of being a long-term investor is the luxury of checking out of the daily financial news cycle. Diversification and a long time horizon silences much of the noise. But, whether or not an individual can actually ignore the news cycle and short-term market changes and not react to them is another story. When the news implies that you should be concerned, it’s hard to stay calm.
At the end of 2015, the Federal Reserve began raising the federal funds rate and the increases have continued this year. These policy decisions are exactly the type of short-term change that long-term investors shouldn’t worry about. But it’s hard when news suggests otherwise—as NPR’s Marketplace reminded me the other day on my drive to work. The story, as with any story discussing a change to interest rates, is obligated to remind the listener that a bond’s price moves inversely with interest rates. In other words, as Interest rates rise, bond prices fall. The visualization looks like this:
It’s that visualization that understandably causes clients to reach out and say, “I heard that interest rates are rising, should I be concerned? Should we be getting out of US Bonds?”
It’s with this concern in mind, that I want to explain first, why rising rates should not be scary; and second, explain why you may even want to look at it as a good thing.
Why rising interest rates shouldn't be scary
- The Primary Purpose is Risk Mitigation
The main reason we shouldn’t fear a rate hike’s detrimental effect on the bonds we hold relates to why we hold them in the first place. The why usually matters, and the primary purpose for bonds in our portfolios is risk mitigation (yield, while it matters, is secondary). For most people near retirement, a substantial portion of their portfolio is likely invested in bonds, however, a large (in many cases larger) portion is also allocated to stocks, and stocks are what historically have been the heavy generators of return. If we look at data back to 1926, there have been ten years where bonds were down, but in only two instances where both stocks and bonds down for the year. The primary driver of return in most portfolios (stocks) were up. But, let’s focus on the years both were down: 1931 and 1969. By far the worst of these is ’31: In 1931, US Bonds (5-year US Treasuries) were down about -2%, and stocks were down -43.8%. Source: Dimensional Fund Advisors. For greater context, this was right in the middle of a time period where US GDP Growth dropped about -28% from 1930 to 1932—clearly a difficult period for the economy and most of its investors. In one of the worst economic periods ever in the US, as stocks plummeted, bonds were only down only -2%! If you had held them in your portfolio they would have mitigated the thrashing that stocks inflicted. In other words, they did what they were supposed to do—mitigated risk.
- Magnitude matters and when bonds are down, they aren’t that down
While the primary purpose is risk mitigation, the yield still matters, and no one wants to lose money in any piece of their portfolio regardless of purpose. After all, the yield is one reason we want them in place of cash. However, the losses should be put into context. Since 1976, bonds have been down three times and those losses were low in magnitude.
- 1994: The Federal Reserve raised rates from 3% to 6%. Bonds were down -2.9%.
- 1999: The Federal Reserve raised rates from 5 to 5.5%. Bonds were down -0.8%,
- 2013: Bonds were down -2.02%, but the S&P was up 32.4% and international stocks were up 16%
Compare this to 2001, 2002, and 2008 where the S&P was down -11.89%, -22.10%, and -37% respectively (bonds were up 11.6%, 8.4%, and 7.0% in the same years), and the bond losses above don’t seem so menacing (source: Yahoo Finance). Further, when you consider what stocks have done when rates have gone up, you might even root for increases.
- Rising Rates have historically meant good things for the economy
Historically, Federal Reserve fund rate increases have come with increased confidence in the economy which is usually a good thing for your portfolio: Take 1992-1999 as an example. Rates rose from 3% to 5.5%. Over this period, the economy grew over 4% percent per year with the exception of 1995 (2.7%). While two of the down years for bonds mentioned above occurred during the period, US stocks had an annualized return of over 19% and International stocks (excluding the US) had an annualized return of 11%. Again, what we look to as the drivers of return (stocks) performed well, and a diversified portfolio would have benefited greatly from the stock market performance despite a couple down years for bonds.
Why you might even root for a rate increase
Point 3 above is one obvious reason a rate increase could be good for your portfolio, but if you are a long-term investor, rate increases could also be good for the bond portion of your portfolio. Remember, as interest rates go up the return on the bonds you currently hold go down, but in a bond portfolio an investor isn’t typically buying just one bond and holding it to maturity. Regardless of whether we are using a fund for bond exposure or directly buying and selling bonds, the bonds one owns are constantly coming to maturity and new bonds are continuously being purchased. The new bonds purchased will have a higher yield if rates have risen. Thus, a rate hike may cause an immediate negative return on the bonds you own, but over the long term, the portfolio will benefit from the newly purchased higher-yielding bonds.
This paper from Sellwood Consulting, LLC lays out three scenarios of rising interest rates over 10 years and details the effect on bonds. Each scenario assumes a portfolio of aggregate bonds that currently yield 3.1% over a decade. It goes without saying, that if interest rates didn’t change at all over 10 years, the return on this bond portfolio would equal 3.1% (the current yield). You can reference the paper to dive into each of the scenarios in greater detail, but here is a summary of the three scenarios and notice that none of them end with a negative return for the bond portfolio:
- Scenario #1: Rates Gradually Rise to the Long-Term Average (4.8%)
- In the case of a gradual interest-rate rise in even increments the annualized return for the aggregate bond portfolio would equal 2.8% - 90% of what the portfolio would have yielded if rates hadn’t changed at all.
- Scenario #2: Rates Rise Quickly to Their Long-Term Average (4.8% in one year)
- A long-term investor should be excited about this. Despite an immediate drop in return, the annualized return for the bond portfolio over the decade would be 3.5%--higher than if rates hadn’t changed at all. I think the visual is helpful to understand how this works. The blue line represents the value of a $100 bond portfolio invested in US Aggregate Bonds and the grey shading represents the interest rate over time:
- Scenario #3: Rates Rise to Their Long-Term Average, 9 Years from Now
- This scenario would be the worst-case-rate hike for the 10-year return of this portfolio because it would occur at the end significantly cutting into the principal of the portfolio. The annualized return would be 2.0% (65% of the return yielded by the portfolio had interest rates not increased).
In all three scenarios rates increase to the long-term average over 10 years, and in all three scenarios the bond portfolio ends with a positive annualized return. And as scenario 2 demonstrates, it’s even possible that the return on the bond portfolio would be better off due to the hike.
So what would it take to get a zero return?
A substantial change. If it happened in year 9 of the 10-year return (a la scenario 3 above), it would take a 4.5% hike from 3.1% to 7.6 %. If it happened gradually (a la scenario 1 above), rates would have to climb 1.85% per year to 21.6%! Both rate changes would be historically radical and, in neither case, does the long-term investor end with a negative return on their bond portfolio.
The long-term investor has the advantage
Bottom line, if you’re a long-term investor, don’t let the visualization of the scale above scare you, or be the sole reason you exit US Bonds the next time you hear about the Fed raising rates. Remember why you hold US Bonds in the first place, put the potential downside in context of what it means for your entire portfolio, and maybe even let some optimism creep in. A long time horizon is a valuable asset in a market where others are forced to buy and sell every day.